Volatility & Momentum
Anyone who’s had money in the markets long enough knows that markets go through periods of relative calm and other periods of stormy & choppy waters. At the core, these movements are driven by momentum of “fear” and “greed” aggregated across all investors in the market – and investors in a given stock. To make rational decisions, it’s critical for individual investors to have a pulse on this volatility, and so the markets have developed some tools.
VIX and IV
At the market level, one of the most widely used indicators of volatility is the “Volatility Index” captured by the “Volatility Index eXchange” or VIX. VIX is a forward looking index that looks at near term expiration options being traded on the S&P 500 and gauges the overall implied volatility of the market. As the overall market waters get choppy, the VIX goes up, and as things get more calm – it comes down. VIX is published only for the S&P 500 index.
Likewise, for individual stocks, there is an indicator called “Implied Volatility” that purports to show volatility (and expected moves) of an individual stock based on the outstanding options contracts for that stock. In theory, this is a useful way to gauge sentiment on the stock and predict where it may move in the near future, but in practice – it has some flaws.
The problem with IV
One major problem with implied volatility is that it doesn’t properly separate underlying market volatility from risk specifically associated with that particular asset. This can lead to false positive or false negative conclusions of an equity based on signals that actually tie to the broader market and not the stock itself.
Another limitation of implied volatility is that it assumes that upside and downside potential are equal. In other words, it can show that underlying sentiment predicts a stock will move a small amount or a larger amount in either direction – but if underlying sentiment has a bias to the upside or downside, this will not be shown.
As our machine learning algorithms crunch through over 500,000 options trades every day – they draw conclusions about underlying volatility of each stock in a more precise metric we call VVOL. Like Implied Volatility, VVOL is inferring the volatility of a stock based on the underlying options trades – but unlike Implied Volatility, VVOL is able to separate macro-market signal from sentiment signal on the underlying asset. I.e., VVOL is a more accurate indicator of implied volatility in that stock – not a mixed sentiment of volatility on that stock and the market. VVOL can range from 1 to 100. Each value is associated with expected move of the asset to the upside or downside and different standard deviation to the upside and downside.
Beyond pure volatility, our algorithms are able to see directionality in the sentiment of options trades. LIkewise, VVOL not only shows the expected move of a stock, it will also show whether there is a bias to the upside or downside in the market sentiment. If there is a bias to the upside, VVOL will show higher potential upside move than downside, and vice versa – if there is a bias to the downside, VVOL will show a higher potential downside move than upside.
The power of VVOL vs IV
In the Kosha dashboard, investors are able to see the market standard Implied Volatility indicator next to our proprietary VVOL metric. Differences in these indicate pricing flaws in the equities – and enable opportunities to make better buy / sell / hold decisions on the stock, or to execute direct arbitrage moves on the mispriced underlying options.
This is the power of VVOL – and Kosha’s ability to take the pulse of the market to give more accurate prediction on equity direction than Implied Volatility can by itself.
We put together a short video explaining how Kosha works in more detail. If you watched it, you saw how Kosha vastly outperformed the market on a model portfolio of 10 household name equities. If you haven’t seen the video yet – you can watch it here: